What price peak oil?

Long-time readers of our forecasts willprobably be aware that, over the last seven years, we have typically expectedworld oil prices to settle back down over the medium-term, usually US$10-15below the prevailing level when we’ve been preparing the forecasts.   Such aview has not been out of line with the received wisdom.   Consensus forecastsfor oil prices over the same period have generally tracked the current oilprice with some downward adjustment expected over the coming year to bring oilprices back to more "normal" levels.   The futures market has generally been alittle less sure of any reversal in prices, but even so, an oil price ofUS$120/bl was never on anyone’s radar even 12 months ago.

With the benefit of hindsight, it hasbecome increasingly clear that the global oil market has entered a new phasesince OPEC tentatively looked to restrict production back in 1999.   At thattime, real oil prices had collapsed to their lowest level since 1973 as theeffects of the Asian crisis saw demand growth for oil in 1998 at a six-yearlow.   Graph 1 plots global oil demand against the real oil price in US dollarsover the last 40 years, splitting the data into four distinct periods.

  • Sixties stability (1965-1973)
  • Seventies shocks (1974-1985)
  • Cartel-less days (1986-1999)
  • Short supply (2000-2008)

Graph 1

A quick history lesson

The 1960s and early 1970s was typified bymassive growth in demand for oil, averaging 7.6%pa over the eight-year period.  Oil prices were incredibly steady during this time, and actually dippedslightly in real terms.   The flat grouping of data points indicates aneffectively unlimited supply of oil (relative to demand) during this period.

OPEC’s restrictions on supply led to a147% increase in the real price in 1974, and a further 114% lift between 1978and 1980.   On average between 1973 and 1985, world oil demand rose at just0.4%pa, although following each of the two price shocks, there were directreductions in demand (2.4% between 1973 and 1975, and 10% between 1979 and 1983).  The more-or-less vertical grouping of data points indicates a fixed supply ofoil and shows the effectiveness of OPEC in restricting the global oil supply.

The breakdown of cooperation in early1986 between the members of the OPEC cartel saw a resumption of stronger globalgrowth in demand for oil as prices and the restrictions on supply eased.  Nevertheless, the disciplines and efficiencies encouraged by the 1970s oilshocks meant that demand growth was much weaker than in the 1960s.   Globaldemand for oil grew on average by 1.7%pa between 1985 and 1999.   Overall demandgrowth during this period was also capped by the collapse of the Soviet Union and the poor performance of the Japanese economy.   Although oil prices wereless stable than in the 1960s, the grouping of data points again maintained arelatively horizontal pattern, indicating a period of essentially unlimitedsupply (relative to demand).

Very low oil prices towards the end ofthe decade saw a renewed push from OPEC to try and restrict supply.   The realoil price rose 103% between 1998 and 2000.   A recession in the US in 2001 temporarily stalled the upward trend in the oil price, but the subsequentpick-up in economic growth meant that there was no need for OPEC to try andrestrict oil production.   Despite soaring prices, world demand for oil hasgrown by an average of 1.6%pa over the last nine years.   The grouping of datapoints for this period is upward-sloping, indicating a traditional supply curve– producers are only able and willing to supply more product as the pricerises.

Peak oil of the second derivative

The oil price experience during thecurrent decade indicates that growth in demand is outstripping growth in supply(extraction and/or refining).   There has been various one-off events overrecent years that have been blamed for driving up prices (eg geopoliticaltensions, Hurricane Katrina), but even once these events have passed, we havenot seen oil prices drop for any lasting time.

Traditional peak oil theory states thatthe supply of oil will, at some stage, reach a maximum and then start declining,as production from existing fields slows down and insufficient new supplysources are found.   Oil prices skyrocket, resulting in the age of industry, andthe world as we know it, coming to an end.   However, global oil production isstill increasing.   Rather than an absolute peak in oil production, the apparentinability of supply to increase as fast as demand is proving to be the criticaljuncture.   Spare oil production capacity previously enabled demand to increasewithout pushing up the price, but that spare capacity has now been exhaustedand supply increases can only be achieved with prices rising also.

Graph 2 shows that the extent of oildemand coming from developing countries, and China in particular.   Chinese oildemand has not only grown by 6.5%pa over the last nine years, but an astounding7%pa on a sustained basis since 1990.   A lack of price discipline due to fuelsubsidies in the Middle East shows up in their demand growth (petrol in SaudiArabia costs NZ15c/l, for example).   Africa, Asia excluding Japan and China,Latin America, non-OECD Europe, and the former Soviet Union have also liftedtheir demand faster than the global average since 1999, although in the case ofthe last two regions, their consumption is still almost 50% lower than 1990levels.

Graph 2

Graph 3 shows oil consumption versus GDP.  The graph indicates that the most highly developed economies are generally alsothe least oil-intensive in terms of output.   In part, this trend reflects themore service-oriented nature of economic activity in developed countries.  However, in many cases it also reflects behavioural changes brought about bypast price shocks, as well as the petrol taxes applied by many governments totry and control fuel demand growth in the 1970s.   In the UK, where petrol taxesare among the highest in the world, the ratio of real GDP to oil consumptionimproved by more than 200% between 1978 and 2006.

Graph 3

Even in the US, where car usage issynonymous with gas-guzzling, the discipline caused by high oil prices isclear.   Since 1978, US oil consumption has risen by just 11%.   At the sametime, the American economy has expanded by 132%.   The 1970s oil shocks(particularly the 1979 event) forced American businesses and consumers tore-evaluate their use of oil, substituting to other energy sources whereappropriate, and ensure that the oil they do consume is used efficiently.

The Malthusians predicting the end ofcivilisation as oil runs out miss one important point – the ability of humansto adapt to changing circumstances.   In the past, we have mentioned some of themarket dynamics that kick in as oil prices rise and, at least in theory, helpto keep the world functioning.

  • Biofuels is hardly an auspicious start to the list.   The US push to increase ethanol production has essentially been a political decision to try and reduce America’s dependence on Middle East energy supplies, and has had the unintended and unfortunateside-effect of pushing up global food prices.   Furthermore, the supposedpositive environmental effects of using biofuels instead of fossil fuels arenow heavily doubted.   Putting aside these issues, given current technology, biofuelsstart to become economic (ie without the need for government subsidies) whenthe price of oil reaches something like US$150/bl.
  • Refining capacity has sometimes been mentioned as a bottleneck inthe supply chain.   Given the length of time it takes to construct andcommission a new refinery, it is possible that increases in refining capacitywill take place over the next few years.   At best, however, this outcome wouldonly temporarily slow the upward trend in world oil prices.   Supply issuesfurther up the chain (ie extraction) will dominate price trends over themedium-term.
  • Changes in extraction processes are now seeing carbon dioxide pumpedinto oil wells, whereas water had previously been used.   The use of carbondioxide dramatically improves the potential yield from existing wells fromaround 30% of the available oil up to between 60% and 80%.   This process changerepresents a potential step up in the extractable oil reserves available.
  • New oil fields and different sources of oil start to become viableas the price of oil rises and is sustained at a higher level.   Sweet, lightcrude oil has historically been the primary energy source, but that supply willstart to be augmented over the next seven years by "heavy" oil fromnon-conventional sources such as tar sands and oil shales.   However, we notethat the local and/or global environmental costs of extracting oil from thesesources are significantly higher.   For example, the Alberta tar sands in Canada require energy from an average of two barrels of oil to obtain three barrels ofoil.   The current emphasis on combating global warming suggests that theappetite for using oil from such sources will only diminish further over themedium-term.
  • Sustained high oil prices mean that other sources of energy becomerelatively cheaper and more viable.   New Zealand’s electricity supply providesan example of this phenomenon – the viability of wind generation was borderlinejust a decade ago, but technological improvements and higher electricity priceshave meant that wind farms have become increasingly common.   Although theworld’s current fleet of vehicles can’t easily be converted to run on differentfuel, a shift away from reliance on fossil fuels is likely over time.   A shiftto other energy sources, such as gas, nuclear power, or wind generation, may bemore quickly achieved for industry and general electricity supply.

Barring short-term cyclical declines inthe pace of economic growth in China, the oil price increases that haveoccurred are likely to be sustained.   We see potential for further real priceincreases over the next decade, with New Zealand petrol prices climbing tobetween $2.90/l and $3.70/l.   Over the longer-term (20+ years), we would expectreal oil prices to start to decline again as the prolonged period of higherenergy costs encourages more efficient use of oil (particularly in developingcountries, but even in developed economies such as the US).   The technologicalimprovements and alternative oil sources mentioned above will also help cap thereal price of oil.   Finally, the world’s reliance on fossil fuels is likely todecrease over the long term as alternative energy sources become relativelycheaper and are thus increasingly utilised in place of oil.

Given the probability of sustained highprices for oil over the next 10-15 years, we have constructed what we believeto be a realistic scenario for oil demand by 2021 (see Table 1).   The scenarioinvolves considerable improvements in the efficiency of oil use around theworld, resulting in static or falling demand for oil in the US, Europe, the Middle East, and Japan.   However, Table 1 also demonstrates that, even withsignificant oil efficiency gains in the US, China, and Asia, global demand foroil is still likely to continue rising throughout the next decade as long aseconomic growth in developing economies remains reasonably strong.

Table 1

The global warming dilemma

It has been interesting to note thepublic attitude over the last few weeks as petrol prices have climbed towards$2/l.   History shows that high fuel prices are an effective method for limitinggrowth in, or even reducing, consumption.   Given the apparent widespreadacceptance that we have to do something to combat global warming, one wouldhave expected an acceptance from the public that high fuel prices are anecessary signal for us to change our behaviour.

Instead, the government has found itselfunder pressure to abandon or delay a number of its key initiatives aimed ataddressing environmental issues.

  • The biofuel targets look increasingly unlikely to be enacted (whichis probably not such a bad thing anyway, even from an environmental point ofview).
  • The imposition of regional petrol taxes looks questionable, despitethe fact that at least some of the revenue generated was to be used forimproving public transport.
  • The incorporation of oil into the carbon emissions trading scheme hasbeen delayed from the start of 2009 until the start of 2011.
  • Various organisations have been calling for cuts to excise dutyand/or GST on petrol.

The depth of feeling over petrol pricesand any the imposition of any further policy-related charges suggests one oftwo things.

  • In principle, people are keen to do something to tackle globalwarming, as long as the cost to them or their lifestyle is not too great.
  • Despite policymakers and the media strongly and repeatedly presentingthe case for global warming, buy-in from the general public remains much lowerthan a casual read of the newspaper might indicate.

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